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YOUR TAXES; Mastering The Form 1040: A Step-by-Step Guide

The Tax Game scarcely rivals the Super Bowl or the World Series as an American favorite. Still, give the matter even a bit of the attention many fans lavish on those contests, and you may be a winner, considerably reducing what you pay Uncle Sam.

As daunting as a tax return may look, approached step by step, it is not difficult to understand. There are essentially two sets of numbers: income and deductions. Overlook any income -- say reinvested mutual fund dividends -- and the Internal Revenue Service will demand its due. Overlook any deductions, or take the standard deduction when you could have itemized, and you won't hear a peep, but you'll pay too much.

A tax professional or a computer program can fill out the forms and do the calculations, but only after taxpayers provide the data. To help taxpayers understand what is needed and how finances can be structured advantageously, Jan M. Rosen of The New York Times used Kiplinger Tax Cut in consultation with Brenda Hochberg, a tax lawyer who heads the Federal tax development team for the Block Financial Corporation, which publishes the program, to prepare this return for a hypothetical two-income family, the Taxpayers. The commentary explains each form, tax rules and strategies.

Filling Out the 1040

The heart of a tax return, the Form 1040, shows all income, adjustments to income and deductions, mostly as bottom-line figures brought forward from attached schedules and forms. Once all those forms have been completed, taxable income and tax liability, along with any refund or payment due, are calculated on the back of the 1040. Using Tax Cut, or a competing computer program, Turbo Tax or its sister program Macintax, all with extensive on-screen reference materials, is much easier than filling out forms by hand. Users simply answer questions in an on-screen interview, and the program puts the answers in all the right places on the forms and makes the calculations.

Like most married couples, the Taxpayers -- Samuel and Felicity -- are filing jointly (Line 2). They are entitled to five exemptions (Line 6) -- two for themselves and one each for their daughter, Heidi; their son, Cyril, and Samuel's father, Sydney, whom they support.

Their income comes from several sources. Felicity and Samuel both had wages, she as a nurse and he as a part-time manager. The numbers from their Forms W-2 are totaled on Line 7. Interest income (Line 8) and dividend income (Line 9) come from Schedule B. The Taxpayers received no state tax refund last year, but people who did must report on Line 10 any amount that was included in itemized deductions on their 1996 returns. Samuel's business income as a consultant (Line 12) comes from Schedule C, and capital gains (Line 13) from Schedule D. They rented out their beach cottage and had a paper loss, thanks to the tax laws (Line 17). That was calculated on Schedule E.

The Taxpayers had adjusted gross income (Line 32) of $120,518 after adjustments of $3,124 (Line 26) for one-half of Samuel's self-employment tax, $11,392 (Line 28) for his contribution to a tax-deferred Keogh retirement plan, and $3,000 for alimony paid (Line 30, where the recipient's Social Security number must also be shown). Alimony is taxable to recipients.

After itemized deductions of $25,852 (Line 35 and Schedule A) and the five personal exemptions worth $13,250 (Line 37), the Taxpayers have taxable income of $81,416 (Line 38).

Their tax of $17,437 (Line 39) is reduced to $17,355 (Line 46) by a credit of $82 (Line 43) for foreign taxes. They own some British stocks, and Britain withholds taxes on dividends. A credit for that tax is calculated on Form 1116 (not shown). They could not claim a child and dependent care credit (Line 40) because Felicity had her employer put $5,000 of her compensation into a tax-free dependent care account, for which they must fill out Form 2441 (not shown). In the Taxpayers' 28 percent bracket, that directly saved $1,400 on taxes, well above the maximum credit of $960 for two, and it saved more by keeping adjusted gross income down.

They are also liable for Samuel's self-employment tax of $6,247 (Line 47 and Schedule SE) and household employment, or nanny, tax of $459 (Line 52 and Schedule H) for Heidi's baby sitter, bringing their total tax to $24,061 (Line 53). After withholding of $16,823 (Line 54) and quarterly estimated tax payments of $6,600 (Line 55), they owe $638 (Line 64), showing good planning. People who get a refund have given the Government an interest-free loan.

Schedule A: Itemized Deductions

Like most other tax-payers, the couple cannot deduct medical expenses (Line 4), which are deductible only to the extent that unreimbursed outlays exceed 7.5 percent of adjusted gross income, $9,039 (Line 3).

They can deduct state and local income taxes of $7,945 (Line 5), real estate taxes of $6,175 (Line 6), home mort-gage interest of $9,312 (Line 10) and gifts to charity of $2,420 (Line 18). If audited, filers must be able to show a receipt from a charity for any single gift of $250 or more. The $275 (Line 16) is for old clothing and toys donated to their parish rummage sale, and it is based on prices at the sale, not on their cost.

Mortgage interest on a first and second home is gen-erally deductible, as is interest on home equity loans of up to $100,000. Points are deductible up front when buying or improving a house but in a refinancing must be amor- tized over the life of the loan.

Felicity had expenses of $1,450 for union dues, nurse uniforms and continuing education (Line 20), but the Taxpayers could not take a miscellaneous itemized deduction (Line 26), which is allowed only to the extent that such expenses exceed 2 percent of adjusted gross income ($2,410 on Line 25).

Banks, brokers, mutual funds and other payers of interest and dividends, including reinvested dividends, must send Forms 1099 to both recipients and the I.R.S. That enables the I.R.S. to identify people who fail to report such income.

In the interest section (Line 1) $875 is from municipal bonds. It is listed and then subtracted out as tax-exempt, leaving taxable interest of $2,015 (Line 4). Dividends of $2,768 (Line 6) include a mutual fund capital gain distribution of $356 (Line 7). It is subtracted, giving taxable dividends of $2,412 (Line 10). The capital gain distribution is also listed on Schedule D, where tax on it is figured. The questions on foreign accounts (Lines 11 and 12) must be answered.

Schedule C: Profit Or Loss From Business

Most self-employed people like Samuel P. Taxpayer must file Schedule C as part of their personal returns, as must others who earned income on which no taxes were withheld, like many company directors or people with sideline businesses. Different forms are used if a business is incorporated or is a partnership.

Income (by which the I.R.S. means revenue) of $100,236 (Line 7) is reduced to net income of $60,086 (Line 31) by expenses listed on lines 8 through 27, totaling $40,150 (Line 28). They include an immediate deduction of $7,500 (Line 13) for computer equipment. Under Section 179, up to $18,000 of equipment and other items may be deducted at once instead of depreciated over several years.

The $4,261 deduction for meals and entertainment (Line 24) is limited to 50 percent of outlays.

Samuel paid rent of $1,200 (Line 20b) for occasional use of an office with conference room. He did not take a deduction for a home office because the room in which he does most of his telephoning, writing and record-keeping is the family den in the evening. He has a separate business telephone line and deducted $2,456 for it under utilities (Line 25).

Samuel regularly worked for one client on the company's premises under its direction, so he was classified as a part-time employee. He received a W-2 for that work, and the income is not included on Schedule C. The I.R.S. is vigilant on the issue of outside contractor versus employee.

Income from rental properties, as well as most income from partnerships, is recorded here. The Taxpayers own a beach cottage. They used it for 10 days and rented it out 120 days.

They received $12,500 in rentals (Line 3), so after outlays of $10,883 (Line 19), they had a positive cash flow of $1,617. But depreciation of $8,073 (Line 20), which is carried from Form 4562 (not shown) brings their total expenses, for tax purposes, to $18,956 (Line 21), giving them a loss of $6,456 (Line 25).

Rental property is deemed a passive activity under tax law, and people with an adjusted gross income above $150,000 may not be able to take a real estate loss against earned income; benefits may be curbed between $100,000 and $150,000 with exceptions for people who qualify as real estate professionals. But this is a relatively small rental activity, and the calculations on Form 8582, Passive Activity Loss Limitations (not shown), allow the Taxpayers to take their entire loss.

In their 28 percent bracket, that paper loss reduces their tax bill by $1,808.

Schedule D: Capital Gains And Losses

Congress provided a break on capital gains in the Taxpayer Relief Act of 1997, but at a price: complexity. There are now three holding periods to consider. ''Short term'' is a year or less, and gains are taxed at ordinary income rates. ''Long term'' has been broken down into two groups. A maximum rate of 28 percent applies to sales before May 7, 1997, or to assets held more than a year but not more than 18 months and sold after July 28, 1997, and to collectibles. Otherwise, long-term securities sales are taxed at a maximum rate of 20 percent.

The Taxpayers sold six stocks and had to add in their mutual fund distribution (Line 13). Two sales resulted in net short-term capital losses of $11,717 (Line 7). The rest, including two taxable at the 28 percent rate (Line 15) resulted in a net long-term gain of $18,694 (Line 16). Altogether, they had a net gain of $6,977 (Line 17).

The second page of Schedule D takes these figures and calculates their income tax liability of $17,437, before credits (Line 54), by a process that defies explanation.

Schedule SE: Self Employment Tax

Self-employment income times a factor of 0.9235 (Line 4a) is taxed at 15.3 percent of the first $65,400 and 2.9 percent on any additional income. That is equal to both an employee's and employer's share of Social Security and Medicare taxes. However, if workers also had employment income, as Samuel did ($28,000 on Line 8), from which such taxes were withheld, self-employment tax is reduced. He owes $6,247 (Line 12). Half his self-employment tax, or $3,124, was deductible as an adjustment to income on Form 1040 (Line 26). That is because employers are allowed to deduct their share.

People who employ household help like baby sitters, maids or gardeners must file Schedule H to pay what has become known as the nanny tax. Such people must also have a Federal employer identification number, entered at the upper right of Schedule H.

The Taxpayers employed Daphne Purr to look after Heidi when Samuel was away on business trips. She earned $3,000, so they had to pay Social Security tax of $372 (Line 2) and Medicare tax of $87 (Line 4). Because her wages did not exceed $1,000 in one quarter, they were not liable for Federal unemployment tax. The total tax of $459 (Line 8) is brought forward to Line 52 of Form 1040.

The $3,000 paid to Ms. Purr came from the $5,000 in Felicity's dependent care assistance account, which is the legal maximum. The rest went to an after-school center for Heidi. That does not show up on the tax return because this filing requirement applies only to taxpayers' own employees, not to agency personnel or au pairs.